529 Plans Roll Out New Perks

Years of Rocky Results Have Spooked Investors; Adding 'Open Architecture'

By

By Kelly Greene

October 29, 2011

What to do when a college-savings plan gets whipsawed by volatile markets? Plan sponsors think they have answers—but some of their solutions are better than others.

So-called 529 plans are state-sponsored accounts for college savers in which any earnings are tax-free as long as they are used to pay for qualified higher-education expenses.

The accounts have grown popular of late: As of Sept. 30, the 529 industry managed $133 billion in college-savings assets, up 12% from $119 billion at the same time last year, according to investment-research firm
Morningstar
.
(Those numbers don't include prepaid tuition plans, which are also classified as 529s.)

But thanks to the market's late-summer swoon, performance this year has been disappointing—especially for families with kids approaching college age. On average, 529 returns through September are down almost 6% compared with the first nine months of 2010, Morningstar says. The October rebound should help, but the volatility has left many people unsettled.

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To keep families from pressing the panic button, a number of states in recent months have made changes to their plans, adding FDIC-insured certificates of deposit and bank-savings accounts, age-based investing options that scale back stock investments for older children and volatility tools, says
Paul Curley,
director of college-savings research at Financial Research.

Deciding whether you need any of the new features depends in part on your 529 plan and the age of the beneficiary.

First, some basics. You can invest in your state's 529 plan or another state's plan, either directly or through a financial adviser. If you invest outside your state's plan, you might lose out on state-tax breaks or discounted fees.

Investors on Edge

The rocky markets of the past few years have investors on edge—and states are responding. At least 16 now offer FDIC-backed bank products, up from five before 2008, says
Joseph Hurley,
founder of information website Savingforcollege.com.

Mr. Hurley says 529 plans sometimes negotiate better CD rates than you could get on your own, though some 529-plan money-market funds can give you a negative return because of program expenses. For parents of students a year or two from college, the bank products can make sense, "as long as you understand that college-tuition rates are increasing much more rapidly than the interest rate on your bank products," he says.

On the other hand, if you have younger children and you don't think the stock market will stay depressed for decades, the CD option might be a bad move. "In my opinion, college is now on sale," Mr. Hurley says. "Your chance that over time you're going to perform better than the market is really high right now."

Age-Based Options

Nearly all 529 plans offer age-based options that scale back equity investments as beneficiaries near college. In the 10 months between September 2010 and August 2011, stock exposure in the years leading up to college declined, according to a Morningstar report released Thursday.

For 14-year-olds, for example, average stock exposure fell to 33% of assets from 39%. At age 18, it dropped to 11% from 15%.

From SmartMoney

Also on Thursday, Morningstar released its annual ranking of 529 plan performance, available on Morningstar's website. Plans in six states earned its analysts' "top" rating, including five from last year—Alaska, Maryland, Nevada, Ohio and Virginia—and Utah.

Last year, Rhode Island's Collegeboundfund was the only plan tagged with a "bottom" rating, but it moved up this year to "below average" after adding low-cost index funds from Vanguard Group (though they are available only to state residents).

Rhode Island's plan manager, AllianceBernstein, in September added a volatility-management tool to its age-based 529 portfolios to reduce exposure to stocks and bulk up on bonds and cash, or even to hedge currency exposures, when it deems appropriate.

The firm developed the tool for its target-date retirement funds, which shift money into more-conservative assets as investors approach their target retirement year. By lowering the risk in its 2010 target-date fund in the third quarter, AllianceBernstein not only decreased volatility significantly but also added more than 2 percentage points of return, says
Chris Nikolich,
a senior vice president at the firm.

In its 529 fund for Rhode Island, AllianceBernstein isn't lowering the risk in its aggressive, age-based portfolios for 10- to 12-year-olds right now, but for 13-year-olds and up, "even though you've defined yourself as aggressive, we still de-risk on your behalf," says Mr. Nikolich. "It's really designed to make the ride smoother over the long haul."

It remains to be seen how well volatility management works over time. "They're taking some of those assets out of equities when they think volatility is going to spike, but there's still a lot on the table in terms of exposure to stocks," says
Laura Lutton,
Morningstar's editorial director.

Outside Funds

Another recent trend: allowing mutual funds managed by firms other than the main manager. In the past year, the total number of such "open architecture" fund offerings jumped to 2,474 from 1,339, according to Morningstar.

For example, Fidelity Investments added funds managed by other firms to 529 plans for Arizona, Delaware, Massachusetts and New Hampshire after research found that 62% of parents said that having a range of firms to choose from within their 529 plan was important to them, says
Joseph Ciccariello,
Fidelity's vice president of college planning.

Adding options managed by other firms increases the fees: While index funds have fees of only 0.25% to 0.35%, the funds managed by other firms within Fidelity's 529 plan cost 0.93% to 1.42%, Mr. Ciccariello says.

Overall, open-architecture investment options cost 0.4% more on average in plans sold by advisers and 0.13% more in plans sold directly by states, Morningstar says. So far, the plans "are having trouble overcoming those fees," Ms. Lutton says.

Many of the recent plan changes come in response to families' concerns about a 529 rule: You can't change your asset allocation more than once a calendar year.

There is a loophole, however. You can change your investment choices if you also change your beneficiary.

"If you have two kids like I do," Mr. Hurley says, "you can change beneficiaries every other day."

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